European Equity Trading 2012/13: Changing the Rules Of Engagement

By Rebecca Healey, Tabb Group

A combination of a deepening economic crisis, increasing regulation, collapsing volumes and commission wallets is escalating the need for immediate action on outdated business models in European equity trading.  The status quo can no longer be maintained.  From investment to execution to settlement, market participants are changing the rules of engagement in order to survive. 

For this year’s buy-side trading study, TABB Group spoke with 60 head traders of equity management firms across Europe, the UK and US. They manage an aggregate €14 trillion in AUM.   The interviews were conducted between August and October 2012.  We included in our conversations the cumulative impact of declining volumes and commission wallets; adjustments to order allocation; the value of the high- and low-touch trading channels; potential changes to broker coverage models; views on today’s market structure; algorithmic providers and product needs; and block trading and risk requirements.

Compared with 2011, the average number of brokers and of these, the number of core brokers, is unchanged in 2012. Yet the commission wallet of our sample set has plummeted, raising the stakes but reducing the amount available to the core brokers and leaving commission scraps for the non-core brokers.

With such little available revenue, both the buy-side and sell-side must act swiftly. Buy side traders are taking on a greater analysis of the services they use, where and whether it adds value.  Sell-side brokerage desks are becoming leaner and struggling to work out viable economic models for their products and services and how to segment their clients.

The situation looks set to continue.  Nearly three quarters of participants are concerned over the growing plethora of arbitrary regulation, its impact on liquidity and order flow execution.  Reduced trading flows mean the traditional order for research payment model is breaking down.

Divorce between research and execution

This divorce between research and execution is being facilitated by the increase use in Commission Sharing Agreements with70% now using CSA’s to pay for research.   As the regulators continue to focus on commission payments, the growth in usage of CSA’s looks set to continue.

As advisory and execution diverges, bulge bracket brokers will either need to provide high-quality sales trading or the buy side will continue its exodus towards algorithms to find the necessary liquidity.  It is a Catch 22 scenario.  The buy side may want to trade more blocks using a sales trader, however with fewer blocks being created, there is less ability to find natural flow.  Continuing fragmentation creates an ever-vicious cycle, more automation creating more passivity, leading to yet more fragmentation. In this environment, greater emphasis on accessing smarter algorithms, monitoring fills and routing logic will become even more critical to achieving optimum execution. As liquidity evaporates, the ability to retain every avenue of execution is critical, dark or lit.  Despite buy side concerns of interacting with HFT toxic liquidity, many are taking the view that any liquidity is better than no liquidity at all, with 60% seeing HFT flow as providing potential liquidity.

However with choice comes responsibility and the scrutiny of execution quality across multiple venues is set to expand further.  The growth of real-time analytical tools will allow buy-side traders to ensure that they access the right flow at the right time on the right venue.

Now is the time for hard choices between which brokers, products and services are required.  As the regulatory wagons roll on, all the players engaged are restructuring their businesses and their roles within them.  Success in 2013 will depend on focusing on individual objectives in order to deliver trading strategies that are optimal in today’s market environment.  Whilst consistent coverage and strong research products will ensure valued trading partners – it is the variety of what constitutes the right European coverage that will provide opportunity for differentiation and ensure a greater share of dwindling commissions.

The complete buy-side trading study from TABB Group is available online here.